At Litchfield Chemical Corp. (LCC), a director of the company said that the use of dividend discount models by investors is “proof” that the higher the dividend, the higher the stock price.

a. Using a constant-growth dividend discount model as a basis of reference, evaluate the director’s statement.

b. Explain how an increase in dividend payout would affect each of the following (holding all other factors constant):

i. Sustainable growth rate.

ii. Growth in book value.

Phoebe Black’s investment club wants to buy the stock of either NewSoft, Inc, or Capital Corp. In this connection, Black prepared the following table. You have been asked to help her interpret the data, based on your forecast for a healthy economy and a strong stock market over the next 12 months.
NewSoft, Inc. Capital Corp. S&P 500 Index Current price $30 $32 Industry Computer software Capital goods P/E ratio (current) 25 14 16 P/E ratio (5-year average) 27 16 16 Price/book ratio (current) 10 3 3 Price/book ratio (5-year average) 12 4 2 Beta 1.5 1.1 1.0 Dividend yield .3% 2.7% 2.8%

a. Newsoft’s shares have higher price–earnings (P/E) and price–book value (P/B) ratios than those of Capital Corp. (The price–book ratio is the ratio of market value to book value.) Briefl y discuss why the disparity in ratios may not indicate that NewSoft’s shares are overvalued relative to the shares of Capital Corp. Answer the question in terms of the two ratios, and assume that there have been no extraordinary events affecting either company.

b. Using a constant-growth dividend discount model, Black estimated the value of New-
Soft to be $28 per share and the value of Capital Corp. to be $34 per share. Briefl y discuss weaknesses of this dividend discount model and explain why this model may be less suitable for valuing NewSoft than for valuing Capital Corp.

c. Recommend and justify a more appropriate dividend discount model for valuing NewSoft’s common stock. LO.1